Not All That Glitters Is Gold

Gross Domestic Product, better known as GDP, is the market value of all final goods and services produced within a country in a given period. That's why GDP per capita is widely used as a summary indicator of living standards in a country. No wonder we keep our eyes closely on its evolution and compare its levels among countries.

GDP can be estimated three ways, which in principle should lead to the same figure. One may sum the value of the output added by every class of producer in the economy and thus arrive at the total. One may also get that value by summing the expenditures on that output made by households, firms, the public sector and foreigners (subtracting what residents buy from abroad). After all, everything that is produced ends up being bought or stored by someone, and therefore those expenditures should equal the total value of what is produced. A third way is to sum all producers' incomes, since wages, profits, rents and taxes are the flipside of the value added in an economy in a given period.

However, GDP is not a flawless measure, especially when it comes to economic welfare. GDP per capita is an average and as such doesn't capture inequality or give a clear picture of poverty, or assess the impacts of economic activity on the environment. It also does not consider the value of leisure and longevity. It certainly doesn't serve as a perfect indicator of the quality of life. Let's take an example included in the Report by the Commission on the Measurement of Economic Performance and Social Progress prepared for the French government by Stiglitz, Sen and Fitoussi: While a traffic jam may increase GDP as a result of the increased use of gasoline, it certainly doesn't qualify as an improvement in quality of life.

But there's something else just as corrosive to GDP's value as a yardstick for living standards. As the latest edition of Economic Premise, "Quality of Government and Living Standards" (co-authored by Francesco Grigoli and Eduardo Ley) illustrates, there is a problem with the way the government contribution to GDP – a significant share in most countries – is measured everywhere in the world: The value to users is assumed to equal the producer's cost! It is as if all government activities were always on the best-practice frontier, and thus an increase (or decrease) in government expenditures can be taken as an increase (or decrease) in the value added to GDP by the public sector.

There are obviously glaring differences in the efficiency with which governments spend money on health care, education, roads etc., not only over time in a country, but also among countries. Therefore, as absenteeism of teachers and health workers, overruns in costs of building roads, and other aspects are not taken into account, directly comparing the government part of GDP – and thus total GDP – among countries may be misleading. Generous wage raises in the public sector may even be straightly counted as increases in productivity.

Grigoli and Ley conducted an interesting exercise. Using indicators of government expenditure inefficiency ("waste") in health and education for a group of 24 countries, and using one of them (Singapore) as a benchmark for best practice, they corrected the other GDPs accordingly to gauge how misleading it is to compare figures obtained through conventional methodologies. On average, meaningful GDP figures should be 4.1% lower, with the loss associated with wasted public resources reaching 7.8% in Portugal.

Let me offer two takeaways. Not all that glitters is gold and one should take with a grain of salt the use of GDP per capita as a measure of living standards. And improving the quality of public spending may be a way to improve living standards without even necessitating official GDP increases.